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HOLY NAME UNIVERSITY

CPA Review
Tagbilaran

MANAGEMENT ADVISORY SERVICES

WORKING CAPITAL MANAGEMENT

Working capital - for financial analysis, working capital equals current assets. For accountants, working
capital equals current assets minus current liabilities.

 Current assets – reasonably expected to be realized in cash or consumed or sold during the normal
operating cycle of the business. These include cash, marketable securities, receivables, and inventory.
o Temporary current assets – current assets, such as cash, that fluctuate with the firm’s operational
needs.
o Permanent current assets – the portion of the company’s current assets required to maintain the
firm’s daily operations. It is the minimum level of current assets required if the firm is to
continue its operations.
 Current liabilities – their liquidiation requires the use of current assets or incurrence of other current
liabiltiies. They include trade accounts payable, unearned reveneus, accrued expenses, short-term debt,
and the current portion of long-term debt.

Working capital management – the administration and control of the company’s working capital. The primary
objective is to achieve a balance between return (profitability) and risk.

Working capital financing policies

1. Conservative (Relaxed) Policy – operations are conducted with too much working capital: involves
financing almost all assets.
2. Aggressive (Restricted) Policy – operations are conducted on a minimum amount of working capital;
uses short-term liabilities to finance, not only temporary, but also part or all of the permanent current
asset requirement.
3. Matching Policy (also called Self-liquidating Policy or Hedging Policy) – matching the maturity of a
financing source with specific financing needs.
4. Balanced Policy – balances are trade-off between risk and profitability in a manner consistent with its
attitude toward bearing risk.

MANAGEMENT OF CURRENT ASSETS

Objectives:
Determination of the appropriate mix of the current assets components (cash, marketable securities, accounts
receivable and inventories) considering safety and liquidity, as well as profitability.

CASH MANAGEMENT
Involves the maintenance of the appropriate level of cash and investment in marketable securities to meet the
firm’s cash requirements and to maximize cash on idle funds.

Cash Conversion Cycle (Operating Cash Conversion Cycle)

- The length of time it takes for the initial cash outflows for goods and services (materials, labor, etc) to
be realized as cash inflows from sales (cash sales and collection of accounts receivable)

Determination of Cash Conversion Cycle

Inventory Receivables Payable Deferral

Cash Conversion Cycle = + -
Conversion Period Collection Period Period
or or or
Average age of Average age of Average age of
+ -
inventory receivables payables

Inventory Conversion
= or
Period or Average age

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of inventories

Receivable
Collection Period or
= or
Average age of
Receivables

Payable Deferral
Period or Average = or
age of payables

CASH FLOW MANAGEMENT

Cash flow can be managed by:
1. Preparing cash budgets
2. Preparing cash break-even chart
3. Determining the optimal cash balance using the Baumol Cash Management Model

CASH BREAK EVEN CHART

1. It shows the cash break-even point - the amount of sales in pesos or the number of units to be sold so
that the total cash inflows is equal to the cash outflows.
2. It shows the amount of cash deficiency when sales is below the cash break-even point, or the amount of
excess cash when sales is above the cash break-even point.

BAUMOL CASH MANAGEMENT MODEL

- An EOQ-type model which can be used to determine the optimal cah balance where the costs of
maintaining and obtaining cash are at the minimum.
- Such costs are the:
o Costs of securities transactions or cost of obtaining a loan;
o Opportunity costs of holding cash which includes the return foregone by not investing in
marketable securities or the cost of borrowing cash.

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Optimal Cash Balance (OC) = √

Where:
T = transaction cost which is a fixed amount per transaction. It includes the cost of securities
transactions or cost of obtaining a loan.
i = interest rate on marketable securities or the cost of borrowing cash.
D = demand for cash over a period of time.

MANAGEMENT OF MARKETABLE SECURITIES

Marketable Securities – short-term money market instruments that can easily be converted to cash.

Examples:
1. Government securities
a. Treasury bills – debt instrument representing obligations of the National Government issued by
the Central Bank and sold at a discount through competitive bidding.
b. CB Bills or Central Bank Certificates of Indebtedness (CBCIs) – represent indebtedness by the
Central Bank.
2. Commercial Papers (CPs) – short-term, unsecured promissory notes issued by corporations with very
high credit standing.

Reasons for Holding Marketable Securities:

1. MS serve as substitute for cash (transactions, precautionary, and speculative) balances.
2. MS serve as temporary investment that yields return while funds are idle.
3. Cash is invested in MS to meet known financial obligations such as tax payments and loan
amortizations.

MANAGEMENT OF ACCOUNTS RECEIVABLE

- Formulation and administration of plans and policies related to sales on account and ensuring the
maintenance of receivables at a predetermined level and their collectability as planned.

Objective: to have both the optimal amount of receivables outstanding and the optimal amount of bad debts.

DETERMINANTS OF THE SIZE OF RECEIVABLE

1. Terms of sale
2. Paying practices of customers
3. Collection policies and practices
4. Volume of credit sales
5. Credit extension policies and practices
6. Cost of capital

AIDS IN ANALYZING RECEIVABLES

1. Ratio of receivables on net credit sales
2. Receivable turnover
3. Average collection period
4. Aging of accounts

MANAGEMENT OF INVENTORIES
- Formulation and administration of plans and policies to efficiently and satisfactorily meet production
and merchandising requirements and minimize costs relative to inventories.
- To maintain inventory at a level that best balances the estimates of actual savings, the cost of carrying
additional inventory, and the efficiency of inventory control.

INVENTORY MANAGEMENT TECHNIQUES

1. EOQ Model
2. Reorder Point
3. Just-in-Time (JIT)

Inventory Models
A basic inventory model exists to assist in two inventory questions:
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1. How many units should be ordered?

2. When should the units be ordered?

ECONOMIC ORDER QUANTITY (EOQ) – the quantity to be ordered, which minimizes the sum of the
ordering costs and carrying costs. It may be computed as follows:

Where: a = cost of placing one order (ordering costs)

D = annual demand in units
K = annual costs of carrying one unit in inventory for one year

 When applied to manufacturing operations, the EOQ formula may be used to compute the Economic Lot
Size (ELS)

Where: a = set up cost

D = annual production requirement
K = annual costs of carrying one unit in inventory for one year

 When the EOQ figure is available, the average inventory is computed as follows:

 Reorder Point:
When to reorder is a stock-out problem, i.e. the objective is to order at a point in time so as not to run
out of stock before receiving the inventory ordered but not so early that an excessive quantity of safety
stock is maintained. When the order point is computed, there may be stock-out situation if:

1. Demand is greater than expected during the lead time; or

2. The order time exceeds the lead time.

Lead time – period between the time the order is placed and received.
Normal Time Usage – Normal Lead Time x Average Usage
Safety Stock = (Maximum Lead Time – Normal Lead Time) x Average Usage

Reorder Point if there is NO safety stock required = Normal lead time Usage

Reorder Point if there is safety stock required = Safety Stock + Normal lead time usage
OR Maximum Lead Time x Average Usage

SHORT-TERM FINANCING DECISIONS

Short-term Credit – debt scheduled to be paid within one year.

SOURCES OF SHORT-TERM CREDIT

I. SPONTANEOUS SOURCES

A. Trade Credit (Accounts Payable) – considered as a spontaneous financing because it is

automatically obtained when a firm purchases goods or services on credit from a supplier.
a. It is a continuous source of financing.
b. It is more readily available than other negotiated sources of short-term credit.
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COST OF TRADE CREDIT

Trade Credit usually bears no interest, but it is not costless. Its cost is implicit in the terms of
credit agreed upon (the discount policy and the credit period).

1. No trade discount
Purchases on credit without trade discount are usually priced higher than cash purchases. The
difference between the selling prices is the implicit cost of credit.

2. With trade discount

If a supplier allows a trade discount for prompt payment, an implicit cost is incurred if the
discount is not availed of.
Example:
Credit terms is 2/10, n/30 - the purchaser is given 2% discount if the account is paid within
10 days.

If the discount is not taken and the purchaser pays on the 30th day, this means that he had 20
days more of financing (30 days – 10 days). The cost of this additional financing is the
discount foregone, which is in effect, a penalty or interest cost. The annual rate is computed
as follows:

Net period or number of days the account is outstanding.

B. Accruals (Accrued Expenses) – another form of spontaneous financing, which represent

liabilities for services that have been provided to the company but have not yet been paid for.
Typical examples are accrued wages and taxes.

Cost of Accruals – None, whether implicit or explicit cost.

C. Deferred Income – customer’s advance payments or deposits for goods or services that will be
delivered at some future date.

Cost of Deferred Income – None.

II. NEGOTIATED SOURCES

A. Unsecured Short-term Credit
i. Commercial Bank Loans – short term business credit provided by commercial banks,
requiring the borrower to sign a promissory note to acknowledge the amount of debt,
maturity and interest.

COST OF BANK LOANS

a. Regular Interest Rate =

b. Discounted interest rate =

c. Effective interest rate =

Usable Loan Amount = Loan amount – Discount Interest – Compensating balance

Compensating balance – a certain percentage of the face amount of the loan that must be
maintained by a borrower on his/her account.
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ii. Commercial Paper – short-term, unsecured promissory notes (IOUs) issued by large firms
with great financial strength and high credit rating to other companies and institutional investors,
such as trust funds, banks, and insurance companies.

COST OF COMMERCIAL PAPER

Example:

Giant Corporation plans to issue P500M in commercial paper for 180 days at a stated, discounted
interest rate of 10%. Dealers of the commercial paper usually charge P200,000 in placement fee
and flotation costs. (Use 360-days in a year.) Answer.

B. Secured Short-term Credit

i. Pledging Receivables – a certain peso amount of receivables is provided by the borrowers as

collateral for a short-term loan.
ii. Pledging Inventories – part or all of the borrower’s inventories are provided by borrowers as
collateral for a short-term loan.

III. OTHER SOURCES OF SHORT-TERM FUNDS

A. Factoring of Accounts Receivable – a factor buys the accounts receivable of a firm and
assumes the risk of collections.
B. Banker’s Acceptances – often used by importers and exporters, these are drafts drawn by a non-
financial firm on deposits at a bank. The bank’s acceptance is a guarantee of payment at
maturity.

EXERCISES:

1. Ben Corporation uses the Baumol Cash Management Model to determine its optimal cash balance. For
the coming year, the expected cash disbursements total P432,000. The interest rate on marketable
securities is 5% per annum. The fixed cost of selling marketable securities is P8 per transaction.

Required: Compute the following

a. The company’s optimal cash balance 11,756
b. The average cash balance 5,878

2. Elaine Corporation is planning to introduce changes in its collection procedures. The new procedures are
expected to make the collection period longer by 10 days, although there will be no change in bad debts.

For the coming year, Elaine Corporation’s budgeted sales is P32,400,000 or P90,000 per day. Short-term
interest rates are expected to average at 9% per annum.

Required:
a. As a result of the changes in collection procedures, the company’s average accounts receivable
balance will increase (decrease) by 900,000 (90,000x10)
b. To make the changes in the collection procedures cost beneficial, the minimum savings in
collection cost for the coming year should be 81,000 (900,000 x 0.09)

3. Che-Che Corporation is planning to change its credit policy. The proposed change is expected to:
 Shorten the collection period from 50 days to 30 days.
 Increase the ratio of cash sales to total sales from 20% to 30%.
 Decrease total sales by 10%.

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Required:
a. If projected sales for the coming year is P40M, what is the peso impact on the average accounts
receivable balance of the proposed change in credit policy? (use 360 days in a year) decrease by
2,344,444
b. What is the impact of the proposed credit policy on the company’s accounts receivable turnover?
Increase to 4.8x

4. Donny traders sells on credit terms of 2/10, n/30. Average daily credit sales is P50,000. On the average,
70% of the customers avail of the discount and pay on the 10th day after purchase, while the rest pays on
the last day of the credit term. How much is the company’s accounts receivable balance? (50,000 x 30) 1,500,000

5. Sisa Corporation has the following data:

Selling price per unit P70

Variable cost per unit P45
Annual credit sales – units 50,400
Collection period 30 days
Rate of return 20%

Sisa Corporation is considering easing its credit standards. If it does, sales will increase by 25%;
collection period will increase to 45 days; bad debts losses are anticipated to be 4% of the incremental
sales; and collection costs will increase by P31,645.

If the proposed relaxation credit standards is implemented, the net benefit (loss) for Sisa Corporatio is
215,000

6. Emil Traders, Inc. sells cellphone cases which it buys from a local manufacturer. Emil traders sells
24,000 cases evenly throughout the year. The cost of carrying one unit in inventory for one year is
P11.52 and the order cost per order is P38.40.

Required:
a. What is the economic order quantity? 400 units
b. If Emil Traders would buy in economic order quantities, the total order cost is 2,304
c. If Emil Traders would buy in economic order quantities, the total inventory carrying cost is 2,304

7. The following information is available for Edgar Corporation’s Material X

Annual Usage 25,200

Working days per year 360
Normal lead time 30 days
Safety stock 1,050

The units of Material X are required evenly throughout the year. Compute for the maximum lead time
and reorder point. 45 days; 3,150

8. Using the EOQ model, Ram Corporation determined the economic order quantity for merchandise item
to be 800 units. To avoid stockout costs, it maintains 200 units in safety stock. What is Ram
Corporation’s average inventory of such merchandise item? 600 units

9. Using the EOQ model, Apple Baby Corporation computed the economic order quantity for one of the
products it sells to be 4,000 units. Apple Baby maintains safety stock for 300 units. The quarterly
demand for the product is 10,000 units. The order cost is P200 per order. The purchase price of the
product is P2.40. The company sells at a 100% markup. The annual inventory carrying cost is equal to
25% of the average inventory level.

Required: Compute
a. The annual inventory carrying cost 2,300
b. The total inventory cost per year 2,000

10. The following information pertains to Emy Corporation’s Product X:

Annual demand 33,750
Annual cost to hold one unit of inventory P15
Setup cost P500
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Beginning inventory 0

At present, the company produces 2,250 units of Product X per production run, for a total of 15
production runs per year. The company is considering to use the EOQ model to determine the economic
lot size and the number of production runs that will minimize the total inventory carrying cost and setup
cost for Product X.

Required:
a. At present, the company’s total annual inventory cost is 24,375
b. If the EOQ model is used, the economic lot size is 1,500 units
c. If the EOQ model is used, the number of production runs should be 22.5 runs
d. If the EOQ model is used, the total annual inventory costs, compared with that under the current
system, will increase (decrease) by 1,875

11. A company obtained a short-term loan from a bank. Information about such loan is as follows:
Principal of loan P5,000,000
Stated interest rate 10%
Terms 1 year

If the loan is discounted, the effective interest rate is ____________ 11.11%

12. A company received a P500,000 line of credit from its bank. Some information about the credit line is as
follows: Stated interest rate, 10%, Compensating balance requirement, 20%. Assuming the company
drew down the entire amount at the beginning of the year, and that the loan is discounted, what is the
effective interest rate on the loan? 14.29%

13. A company received a line of credit from its bank. The stated interest rate is 12%, deducted in advance.
The line of credit agreement requires that an amount equal to 20% of the loan be deposited into a
compensating balance account. On March 1, the company drew down the entire usable amount of the
loan and received the proceeds of P340,000. How much is the principal of the loan? P500,000

14. A company purchases merchandise from its supplier on credit terms of 3/10. n/30. What is the
equivalent annual interest rate (use 360 days) if the company foregoes the discount and pays on the 30th
day? 55.67%

15. What is the current price of a P100,000 treasury bill due in 180 days on an 8% discount basis? P96,000

16. A company’s policy is to maintain a current ratio of at least 2:1. At present, its current ratio is 2.5 is to 1.
If current liabilities at present amount to P250,000, what is the maximum amount of short-term
commercial loan that can be obtained by the firm to finance inventory expansion without violating its
current ratio policy? P125,000

17. A company obtained short-term bank loan of P500,000 at an annual interest rate of 10%. The bank
requires that a compensating balance of 20% be maintained in the borrower’s account. The
compensating balance will earn interest of 2% per annum, payable on the maturity of the loan.

Even before the approval of the loan, the company has been maintaining a balance of P50,000 in the
account. Thus, in compliance with the bank’s condition, the company will just deposit form the loan
principal an amount of P50,000. What is the effective interest rate of the loan? 10.89%

18. The expected boom in business in the coming period led the Baby Apple Company to decide to expand
its operations. The expansion requires an increase of P500,000 in working capital, which the company is
considering to finance through any of the following alternatives:
1) Pledge the accounts receivable. The company’s average accounts receivable is
P625,000 per month. A financier will lend 80% of the face value of the receivables at
10% interest per annum, payable on the maturity of the loan. 10%
2) Issue P515,000 of 3-month commercial paper to net P500,000. New paper will be
issued every 3 months. 12%
3) Borrow from a commercial bank an amount that will net P500,000 after deducting
compensating balance of 15% and interest of 5%. 6.25%

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Required: Compute for the annual cost of all alternatives. Use 360-day year.

19. Lei Company enters into an agreement with a firm that will buy Lei Company’s accounts receivable and
assume the risk of collection. Details about the agreement are as follows:

Average amount of receivable to be factored each month P500,000

Average collection period 60 days
Amount to be advance by the factor 80% of the face of the receivables
Interest rate, deductible in advance 10% p.a
Factor’s fee, deductible in advance 2%
Annual savings of Lei Company in collection expenses P60,000

Required:
a. How much is the monthly net proceeds from factoring the receivable? 383,333
b. What is the annual net cost of factoring? 100,000
c. What is the effective annual cost rate of factoring? 26.09%
d. If the interest charge and factor’s fee is not deducted in advance, the effective annual cost rate is?
25%

20. Loi often factors its account receivable. The factor requires a 10% reserve and charges 2% commission
on the amount of receivables factored. The remaining amount is further reduced by an annual interest
charge of 12%. At the beginning of the month, the company factored P500,000 of accounts receivable
due in 60 days and received net proceeds of (Use 360-day year) 431,200

21. Jem Traders, Inc. needs P100,000 to pay a supplier’s invoice for merchandise purchased with terms of
2/10, n/30. Jem Traders wants to pay on the 10th day of the credit term so it can avail of the 2% discount.

The funds needed can be raised by obtaining a short-term loan from a bank which agrees to grant a 30-
day loan at 12% discounted interest per annum. The bank requires that a compensating balance of 10%
be maintained in the borrower’s non-interest earning deposit account.

Required:
a. The amount needed by Jem Traders to pay the invoice within the discount period is 98,000
b. The principal amount of the loan that must be obtained from the bank to raise the needed fund is
110,112
c. What is the effective interest rate of the loan? 13.48%
d. If Jem Traders fails to pay within the discount period and pays the account on the 30th day of the
term, what is the annual cost of this non-free trade credit? 36.73%

-END OF HANDOUTS-

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